According to a recent study of European Pension Funds by the EDHEC-Risk Institute conducted as part of the Axa Investment Managers research chair, a significant number of funds are not defining their liabilities. The study of 129 asset/liability management specialists (pension funds, their advisers, regulators, and fund managers), discovered that liability-hedging portfolio (LHP) is poorly defined at 45% of pension funds and 25% of pension funds have not defined their liabilities precisely.
GlobalCustodian.com speaks to Samuel Sender, applied research manager, EDHEC-Risk Institute, author of the report, about the consequences of these findings:
25% of pension funds are not defining their liabilities precisely. What are the consequences of this?We know there are modern techniques that allow you to manage risk, such as your minimum-funding ratio. The first step to apply these techniques is to identify and define portfolios according to their objectives. The first is to replicate your liability though a liability-hedging portfolio, and then you have a different objective which involves seeking performance. If you haven’t defined your liability-hedging portfolio in advance, then it will be more difficult to switch your asset allocation to the liability-hedging portfolio when times are more difficult in order to reduce risk. The identification of those two portfolios (liability-hedging and performance-seeking) gives you flexibility and allows you to become riskless when you need to be.
Why havent pension funds defined their liabilities?It is a matter of technique. People used to rely on black-box optimisation. That was fine when they did not have any constraints, but when you need to manage a risk budget you need to be timely and prepared. When the crisis is happening, time runs a lot quicker, so you need to be able to change your asset allocation swiftly. Only identification of portfolios and a definition of allocation rules allows you to react quickly.
You mention in the report that the challenge for pension funds is to gain access to performance through optimal diversification within and between asset classes. Most respondents to your survey used market indices to define the investment benchmarks of investment funds. What is the problem for pension funds using market indices to define benchmarks for their funds?If you want to diversify, you never go with something that is cap-weighted. BP was 9% of the FTSE 100, and the top five largest caps took up 30% of the FTSE 100. So what you buy is not 100 stocks but an equivalent of approximately 30 equally weighted stocks.
Pension funds are very long term investors who dont have liquidity constraints. Banks, on the other hand, need liquidity. You have these two types of investors, pension funds should be providing liquidity, which means investing in illiquid assets. What was surprising was the amount invested in alternative assets, which was not very high. A lot of people have invested low amounts in hedge funds.
You found that 60% of pension fund portfolios include hedge funds, which seem inconsistent with the notion of a liability-hedging portfolio. What is wrong in using hedge funds in a liability-hedging portfolio?
For liability hedging, you want to hedge interest rates, and inflation. But a hedge fund is something that has its own strategy, they dont aim to replicate a form of liability, they aim for performance.
How easy is it to switch from liability to performance portfolios?I think it is very easy to switch if you have rules. If you have rules, when volatility rises and your funding ratio deteriorates, you can modify your allocation between these two portfolios very easily. Something that is more complex is to know how costly this could be. The bigger you are, the more friction you have, but for most pension funds the cost is not in switching, the cost is in failing to switch and being trapped in deficits.
The report can be found here